Below is a financial lease example with a guaranteed residual value.

Depending on the terms between the lessor and lessee, a residual value can be guaranteed by the lessee or by a financially capable third party not related to the lessor. It is the amount that both the lessor and the lessee consider a final lease payment, at the end of the lease.

Transaction Details for the Lease With Guaranteed Residual Value

On January 1, 2022, Mary Company leased a machine from Moira Company for 10 years with the details as follows:

Lease payments every December 31                           CU 2,000,000
Useful life of the machine                                                        12 years
Incremental borrowing rate                                                           14%
Implicit interest rate                                                                        12%
Present value of an ordinary annuity of 1 for 10 periods
12%                                                                                                5.6502
14%                                                                                                5.2161
Present value of 1 for 10 periods
12%                                                                                               0.3220
14%                                                                                               0.2697

The mathematical table for the present value of 1 and an ordinary annuity can be obtained here – https://accountingupgrade.com/mathematical-tables/.

Dian Company guarantees that the residual value of the machine is CU 1,000,000 at the end of the lease.

Since there is a guaranteed residual value, there is no more purchase option since the machine will be reverted to the lessor at the end of the lease.

Cost of Right of Use Asset

Present value of lease payments (2,000,000 x 5.6502)                                             11,300,400
Present value of guaranteed residual value (1,000,000 x  0.3220)                              322,000
Right of use asset/lease liability                                                                                       11,622,400

The present value factor for 12% was used in computing the present value of the lease payments since it is the implicit interest rate. However, if the implicit interest rate cannot be readily determined, the lessee can use the incremental borrowing rate.

Table of Amortization

Present value – we have recorded above the recognition of the CU 11,622,400 right-of-use assets which is the present value of the lease payments plus the amount of the certain bargain purchase option as shown in the table below. The present value is the balance of the lease liability after deducting the annual principal payments.

Payment – is the annual lease or fixed payment which is CU 2,000,000.

Interest – is equal to the foregoing present value multiplied by the implicit interest rate of 12%. Thus, for 2022, the interest is CU 11,622,400 x 12% = CU 1,394,688, and for 2023, the interest is CU 11,017,088 x 12% = CU 1,322,051, and so on.

Principal – is the portion of annual rental payments less interest. Thus for 2022, the principal payment nets to CU 605,312 (CU 11,622,400 – CU 1,394,688).

Journal Entries for 2022

1. To record the right-of-use asset and the lease liability:

Dr. Right of use asset                                      11,622,400
Cr.             Lease liability                                                 11,622,400

2. To record the first lease payment on December 31, 2022.

Dr. Interest expense                                        1,394,688
Dr. Lease liability                                                 605,312
Cr.              Cash                                                                2,000,000

Interest expense and lease liability are obtained from the table of amortization which is as follows:

Payment on December 31, 2022                                                        2,000,000
Interest amortization for 2022
Lease liability, January 1, 2022                        11,622,400
Multiply by the implicit interest rate                            12%
Interest for 2022                                                                               1,394,688
Principal amortization                                                                         605,312

3. To record the depreciation for 2022.

Dr. Depreciation                                                 1,062,240
Cr.            Accumulated depreciation                              1,062,240

The asset is depreciated over the lease term of  10 years since there is neither a transfer nor a reasonably certain purchase option to be exercised.

The depreciable amount is equal to the cost of the right-of-use asset minus the guaranteed residual value amounting to CU 10,622,400 (CU 11,622,400 cost – CU 1,000,000 residual value).

Return of the Machine to Lessor on December 31, 3031

Since it is a lease with guaranteed residual value, the machine will be returned to the lessor at the end of the lease term. Here are then the entries to record the return of the asset.

Dr.     Accumulated depreciation                             10,622,400
Dr.     Lease liability                                                      1,000,000
Cr.                    Right of use asset                                                    11,622,400

The accumulated depreciation is determined as follows:

Annual depreciation                            CU 1,062,240
Multiply by lease term (in years)                          10
Accumulated depreciation               CU 10,622,400

The lease liability is the remaining amount after the annual principal and lease payments as shown in the amortization table above.

As we can see, there is no payment by the lessee to the lessor since the asset is simply transferred back to the lessor at the end of the lease term. Essentially, the essence of a lease with a guaranteed residual value – is to be returned to the lessor and to satisfy the liability for the residual value guarantee.

Additionally, we can also observe that the remaining carrying amount of the right of use asset is equal to the residual value guarantee.

Fair Value of Returned Asset Less Than the Guaranteed Residual Value

If ever the actual value of the underlying asset at the end of the lease is less than the guaranteed residual value, a loss is reported for the difference and the lessee must make up for the difference with a cash payment.

Thus, if the fair value of the machine on December 31, 3031 is only CU 500,000, which is CU 500,000 lower than the residual value of CU 1,000,000, an additional entry to record the loss is necessary.

Dr.     Loss on finance lease                          500,000
Cr.                   Cash                                                           500,000

However, if the fair value of the asset is higher than the residual value guarantee, there is no more additional entry since there will be no cash settlement anymore from the lessee. Accordingly, the lessor will not reimburse the lessee for any excess of the fair value as compared to the guaranteed residual value at the end of the lease.

Next Lesson – Accounting for Initial Direct Costs in Leases